"Ambiguity Attitudes and the Leverage Cycle" with Ester Faia and Valeria Patella; Journal of International Economics, Volume 129, March 2021, 103436
Financial crises originate in debt markets, where beliefs formation about asset values affects collateral constraints tightness and leverage cycles. We introduce novel state-contingent ambiguity attitudes, which endogenously induce pessimism in recessions and optimism in booms, in a model with occasionally binding collateral constraints and exogenous debt supply. Ambiguity is measured in the data through GMM estimation of the Euler equations, and delivers over-extrapolative behaviors through a comparison with forecasters beliefs wedges and forecast errors. Analytically and numerically (global methods), it is shown that the model explains asset price and debt cycle facts. Optimism heightens the build-up of debt and asset prices prior to a crisis event, pessimism heightens the de-leveraging following it; jointly they also induce leverage growth pro-cyclicality.
Media: VoxEU column
Previous versions: CEPR Discussion Paper 13875
Working Papers (with review process)
"Macroeconomic Dynamics of the Output Floor" with Ivy Sabuga and Jonathan Smith [Forthcoming Bank of England Staff Working Paper]
We use a DSGE framework to assess the macroeconomic effects of the output floor, a new regulatory constraint recently introduced in the Basel III framework. The main purpose of the output floor is to reduce the excessive volatility of banks’ risk-weighted assets and ensure a robust level of capital requirements. Our assessment concludes that in both normal and crisis times, the output floor reduces the volatility of the risk-weighted assets and, in turn, the banks’ capital-to-RWA ratios. This contributes to tame the credit cycle, by mitigating the excessive expansion (reduction) of credit during a boom (bust). These results support what the Basel Committee on Banking Supervision (BCBS) envisioned in introducing the output floor. However, our model predicts that the output floor might trigger banks behavioral reactions. More specifically, banks may have the incentive to shift their portfolio from a less risky mortgages to a more risky non-financial corporation loans.